Income Strategy Update: Balancing Opportunity With Resiliency

After months of market turmoil – and despite recession risks – yields, valuations, and total return potential appear very attractive for fixed income investors. Here, Dan Ivascyn, who manages PIMCO Income Strategy along with Alfred Murata and Josh Anderson, talks with Esteban Burbano, fixed income strategist. Ivascyn discusses why he sees better value for active fixed income managers than he has in years and how the portfolio is currently positioned.

Q: In the third quarter, the Bloomberg U.S. Aggregate Index was down nearly 5% as yields climbed. What drove the sell-off?

Ivascyn: Extreme global uncertainty, both economic and geopolitical, drove the sell-off in both high quality and economically sensitive areas of the market, leaving few places to hide. As central banks continue to tighten policy, war rages in Europe, and tensions flare between the West and China, the trajectory of inflation and timing of a potential recession remain unpredictable.

Q: Given the broad sell-off we have seen year to date, along with the potential for recession, what is our outlook for fixed income?

Ivascyn: Despite global economic challenges, in our view fixed income markets can offer better value than they have in many years. Yield has returned. We are able to target robust potential returns without taking a tremendous amount of risk. Caution and selectivity are required, however. We are concentrated in high quality assets in areas that are not too economically sensitive until we see a point – possibly next year – to add lower-rated risk.

Q: How are you thinking about inflation risk and its potential impact on the global economy?

Ivascyn: We think inflation in the U.S. has likely peaked or is near the peak, and will decline meaningfully through 2023, but then plateau at levels above central bank targets. Over the past several months, we’ve seen inflation broaden beyond categories affected by pandemic-related production disruptions to include more cyclical areas like shelter and services, which may prove stickier. Our base case view calls for a mild-to-moderate recession in the U.S. as the Federal Reserve’s (Fed) policy tightening takes effect, although we think a soft landing is still possible.

In Europe, inflation and recession risks appear even further elevated. The war in Ukraine poses significant risks that food and energy costs will rise going into the winter months, further slowing the economy. And in the United Kingdom, a lot of sticky inflation and policy uncertainty have fueled tremendous market volatility.

In China, however, we're not seeing the same degree of inflationary pressures as in the U.S. and Europe. We are seeing significant economic weakness emanating from the country’s zero-COVID policy, property-sector recession, and falling exports to developed economies.

Given uncertainty around the path of inflation we think inflation hedges make sense in the Income Strategy. U.S. Treasury Inflation-Protected Securities (TIPS) have been a core holding in the Income portfolio for many years, which should provide some additional cushion if inflation remains elevated for an extended period of time or if inflation were to rise even higher.

Q: With the Fed tightening aggressively, how are you positioning interest rate risk in the portfolio?

Ivascyn: Markets are pricing in a fed funds rate near 5% in 2023 (from 3.75%–4.00% currently). We think yields are now sufficient to compensate for this uncertainty. After starting the year with very defensive interest rate risk positioning relative to most passive alternatives, we used the sell-off to take our interest rate exposure a bit higher. It’s still below broad fixed income benchmarks, including the Bloomberg US Aggregate Index. If yields rise further, we will likely moderately add duration (interest rate sensitivity), which means we should benefit if the economy turns down and interest rates begin to decline.

As a firm, we continue to prefer U.S. duration while underweighting Japan and the U.K. In fact, we have benefited from the recent sell-off in the U.K.

Q: What is our outlook for housing, and how is the Income portfolio positioned in both agency and non-agency mortgage-backed securities (MBS)?

Ivascyn: With mortgage rates more than tripling in just a few months, we expect U.S. home prices to lag inflation and potentially decline. Yet we continue to see a lot of value in higher-quality mortgage-backed securities.

For example, agency MBS – very liquid instruments that benefit from a U.S. government agency guarantee – offer robust spreads last seen during the dysfunction of the first quarter 2020 COVID crisis. We focus on the higher-coupon issues that we believe will be less exposed to Fed activity, since the Fed holds mostly lower coupons.

In the non-agency (i.e., non-government-guaranteed) MBS sector, we are much more cautious. Our allocation remains concentrated in legacy non-agency mortgage positions that have benefited from meaningful equity buildup over many years of rising home prices and now carry low loan-to-value ratios that we believe will perform very well, even through a sustained housing market downturn.

Q: What is PIMCO’s view of the securitized credit market?

Ivascyn: This is an exciting area for the portfolio. Amid extreme economic uncertainty, we favor high quality securitized products over credit alternatives because they are backed by a lot of collateral. As such, we don't have to take a high risk of downgrade or principal loss to generate attractive returns for an income-oriented investor.

The market volatility over the last several weeks has enabled us to add attractive AAA exposures at spread levels that are 2%, 2.5%, or even close to 3% above Treasuries. Importantly, these securities are rated AAA not only by the rating agencies but also by our internal credit research teams. We’re poised to add more significant exposure going into year-end, when we expect sellers in need of liquidity to emerge.

Q: Within corporate credit, how are you balancing wider spreads with rising recession risks?

Ivascyn: Overall we remain cautious. Senior financials remain a core focus, banks in particular. These securities can be more volatile than other types of corporate credit risk but banks have historically high levels of capital (required by post-global-financial-crisis regulation) and the spreads of their senior securities have widened more than we think fundamentals suggest they should.

On a tactical basis, we are taking advantage of volatility to add other high quality forms of investment grade credit risk. We are also selectively targeting high yield fixed-rate bonds of companies with strong balance sheets but where spreads have widened in sympathy with those of more economically sensitive areas.

In general, within the high yield corporate credit space, we have chosen to emphasize liquidity, with exposures to indices that continue to trade at attractive levels and should outperform other areas of the corporate market in a more stressed environment.

We remain very cautious in more interest rate-sensitive areas that we think may be vulnerable to downgrades or defaults. One example is senior secured bank loans. These are floating-rate assets of companies that are feeling the direct brunt of higher policy rates.

Q: How are you positioning the portfolio’s emerging markets allocation given the headwinds of increased geopolitical risk, a stronger dollar and a potential recession?

Ivascyn: We’ve reduced our emerging markets exposure over the past year, but hold small exposures in higher-quality, more liquid segments of the market: sovereign and quasi-sovereign risk. We also hold a modest diversified basket of emerging market currencies, primarily commodity-exporting countries that have benefited from higher energy and food costs and performed well, even versus the U.S. dollar.

Q: Amid elevated recession risks, what should investors expect from the Income Strategy and fixed income markets in the following months?

Ivascyn: This year has been challenging. But fixed income yields and valuations now look very attractive. Given current economic uncertainty and volatility, it will be tough to call a bottom in prices or a high in yields. But at these levels, we believe there is more of a cushion to offset any further price declines, and the market volatility provides opportunities when valuations overshoot what we think is fair value. And in our view we don’t have to take a lot of interest rate uncertainty to seek attractive potential returns – not only yields, but total return. So we think investors should be more confident about returns going forward; I know the Income team certainly is more confident than we've been in a long time.